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5 Reasons Why Emerging Market ETFs Are Still a Buy

The emerging markets (EM) equities are on a tear this year on global growth slowdown which have kept interest rates low for long and bolstered demand for high-yielding securities. The popular emerging market ETF iSharesMSCI Emerging Markets ETF ((EEM - Free Report) ) has added about 15% so far this year (as of August 29, 2016), bucking the downtrend seen in previous years.

Investors should note that the fund shed about 15.1% in 2015, 0.05% in 2014 and 5.5% in 2013 thanks to hard landing fears in China, Fed rate hike worries and currency concerns. This year’s gains in EEM surpassed about 7% gains (as of August 30, 2016) in the S&P 500-based ETF (SPY - Free Report) , 5.3% advancement seen in all-world ETF (ACWI - Free Report) and 2.4% losses in Europe ETF (VGK - Free Report) . In fact, EM equities saw the seven-year best first-half in 2016 (read: EM ETFs Had a Seven-Year Best 1H: Will the Surge Last?).

Rate Hike in the Cards: What Will Happen to EM ETFs?

Now, with chances of a Fed rate hike this year doing rounds thanks to an improving U.S. economy and hawkish comments by a few Fed officials, clouds started forming over the skies of EM investing.

The common perception is that if the Fed tightens policies, the greenback will regain its lost ground, benchmark U.S. Treasury yields will start rising, which in turn will dull the lure for EM equities.

But will this fundamental hold true this time as well? Probably not. We’ll tell you why.

Though it is too early to take a call at this stage, the initial hints are in favor of EM investing. We would also like to note that the renowned research house BlackRock upgraded its outlook on emerging market stocks. Also, ABN AMRO believes that EM economies are much more insulated from Fed tightening shocks this time than they were in previous periods.

Higher Treasury Yields Not Always Bad for EM

As per Deutsche Bank, the correlation between EM performance and the benchmark U.S. Treasury yields since 2010 has been positive except for 2013, when taper talks weighed heavily on emerging market securities. In 2013, the correlation between EM equities and the U.S. 10-year yield was negative 69%. But if we strip out that period, the correlation turns out to be positive 74%.

EM Growth Rates Higher than Developed world

As per IMF, emerging market & developing economies grew at 4% in 2015 and are expected to expand at 4.1% in 2016 and at 4.6% in 2017. These are higher than the global growth of 3.1% seen in 2015 as well as 3.1% and 3.7% expected for this year and the next, respectively.

The U.S. economy expanded 2.4% in 2015, will likely grow 2.2% this year and 2.5% in 2017 while the Euro zone’s growth rate was 1.7% in 2015. The common currency bloc will likely slow down to 1.6% this year and 1.4% in 2017.

So, one can see from these data that EM growth rates are higher than the developed economies and will likely continue to stage an uptrend, according to IMF.

Several EMs on Policy Easing

To boost growth, several emerging economies have been resorting to policy easing via interest rate cuts or offering some other accommodative measures. Among the pack, China, India, Turkey, Russia and Indonesia deserve a mention. Many of the emerging economies are enacting pro-growth reforms now. So, higher growth rates should offer investors both capital gains and solid yields.

Low Interest Rates Worldwide = Hunt for Yields

Globally interest rates are at low levels, especially in the developed world. Several central banks including the Euro Zona and Japan are practicing negative interest rates in order to shore up growth and mitigate deflationary threats.

Though the Fed is on the policy tightening mode, the jump in yields would likely be the most in the short part of the yield curve, when the step will actually be taken this year. Benchmark 10-year U.S. Treasury yield will likely be less hurt. Investors should note that even after heightened talks about a sooner-than-expected Fed rate hike, the yield on the 10-year U.S. Treasury note was still low at 1.57% on August 29.

All in all, such low interest rates worldwide would push global investors toward EM ETFs (for higher yield) this time, unlike what we saw amid the taper tantrum in 2013, when the benchmark U.S. Treasury yield crossed 3% (read: Time for These EM Dividend ETFs?).

Compelling Valuation for EM Equities?

As per BlackRock, “EM equities are trading at a 24% discount to global developed markets on forward earnings multiples”, giving further room for run. Plus, BlackRock indicated that already Asian investors are shifting toward equities as “local bond yields have dropped to new lows.” And if local bond yields keep falling, there will be more opportunities for Asian EM equities ETFs (read: Yield Hungry Investors Gobble Up EM Bond ETFs).

Calamos Investments provided an interesting fact that “in the seven declines of at least 25% in the MSCI EM index since inception in 1988, the index rose an average of 37% over the next six months, and 63% over 18 months.” Now, EEM has appreciated by 32% since it touched this-year’s low in mid-January. So, now if we go by the Calamos Investments’ thesis, more gains are in store.

Notably, EEM has attracted about $2.19 billion in assets in August while iShares Core MSCI Emerging Markets ETF (IEMG - Free Report) has garnered about $1.15 billion in assets in the month (as of August 29, 2016).

ETF Picks

Below we highlight a few EM equites ETFs that have higher chances of outperforming ahead.

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